India Ratings and Research (Ind-Ra) says that following demonetisation and political interferences, microfinance institutions (MFIs), including non-banking finance companies (NBFCs) and small finance banks (SFBs), with exposure to states (Uttar Pradesh, Uttarakhand, Maharashtra and Madhya Pradesh) faced with asset quality overhang stare at significant credit costs and capital erosion in FY18.

Demonetisation Brings Inherent Issues to Fore: The current upheaval has validated Ind-Ra's earlier opinion of borrower overleverage and idiosyncratic and systemic risks (due to political ecosystem) prevalent in the industry. Furthermore, borrower discipline, a key ingredient for the smooth functioning of microfinance, has severely deteriorated in certain districts of affected states and may take years to be restored. In addition, MFIs need to structurally look beyond joint liability group (JLG) loans for loan growth and product diversification by building capabilities.

Collection Pick-Up Slower than Ind-Ra Expectations: Ind-Ra's analysis of MFIs within and outside of its coverage indicates that the aggregate collection efficiency (CE; collection/billing for that month; aggregate CE includes CE for the period November 2016-May 2017) of the majority of MFIs (with significant exposure to affected states) on portfolio outstanding as of December 2016 was 75%-80% in May 2017 compared with a low of 50%-60% in December 2016. Maharashtra was one of the worst affected states, with monthly collections in some districts in single digits. During the revival period after December 2016, the intensity of political interference in affected states was such that demand for loan waivers did not die down in some districts even after local elections.

Equity Erosion Possible: Ind-Ra's analysis indicates that in case collections (on portfolio as on 31 December 16) do not increase from the current level, MFIs with significant exposure to affected states and with aggregate loans under management of INR10 billion and above could incur credit costs and capital erosion and, thus, higher leverage. At 80%, these MFIs could require an equity of INR1 billion-3 billion (depending on loans under management) to ensure their capital levels remain over the regulatory minimum. The aggregate recovery level on the December 2016 portfolio should exceed at least 85% by 2QFY18-3QFY18 to prevent capital erosion beyond the regulatory minimum, without additional infusion for some MFIs. At 95% collections on portfolio at end-December 2016, MFIs are likely to witness marginal capital erosion.

Lower-than-worse-case credit costs and equity erosions are supported by the fact that 15%-20% of assets under management of MFIs are off-balance-sheet, where credit enhancements, over-collateralisation and first loss default guarantees could range between 5% and 15% (on an aggregate basis).

Unintentionally Defaulting Borrower Unlikely to Clear Four or More EMIs: Ind-Ra's borrower interactions over the last six months indicate that earning members have lost one-three-month wages/income due to demonetisation in FY17. However, business almost recovered in 1QFY18. The analysis suggests that incremental incomes of such borrowers in FY18 would be enough to repay three missed EMIs at best. However, MFIs may need to take haircuts on borrowers that have missed more than three EMIs or are intentional defaulters. The extension of loans by three months may work if default is unintentional.

Focus on Idiosyncratic Risk Mitigation: Microfinance: Borrower Overleverage Warrants Course Correction from MFIs indicated that MFIs need to go back to basics by focusing on vintage, quality of penetration (incremental borrowers to be new-to-microfinance), low ticket sizes, product diversification (one size fits all approach may not be incrementally fit for its borrowers). Ind-Ra opines that investors in MFIs need to increase their investment horizons to enable MFIs to develop tested products over one-two loan cycles. Over time, the regulator may relook at qualifying asset requirements to expand the target borrower segment for MFIs.

Time to Look Beyond JLG: Ind-Ra acknowledges that JLG loans address an important credit need and have an important role in financial inclusion. However, borrower selection and operating processes need to be reassessed, as pointed in Microfinance: Borrower Overleverage Warrants Course Correction from MFIs. Moreover, MFIs need to develop expertise in other secured and unsecured credit products and roll them out gradually (early experience not pleasant for most MFIs). Instead of pursuing growth, they need to adopt best practices of NBFCs, minimise employee churn, and innovate lending and risk sharing mechanisms.

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